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ETF News And Commentary

The Aerospace and Defense industry depends largely on the spending pattern of government departments for growth, with the U.S. defense budget having a direct bearing on the sector. While U.S. defense spending has been affected by the Budget Control Act of 2011 in recent times, several other opportunities of growth have kept the sector afloat.

As a background, the sequester, put into effect in March 2013, resulted in broad budget cuts (at least to the rate of growth in most segments). These were, however, made in an even manner between the defense and non-defense categories.

This slowdown in defense spending compels companies to often fall back on joint ventures, strategic alliances and big international orders to pool their resources, allowing them access to new markets (Read: Can The Defense ETFs Soar Despite Headwinds?).

In fact, the impact of budget sequestration proved to be less-than-feared. This has led to a rally in the Defense and Aerospace securities across the board.

A pick up in defense spending in certain other countries such as India, Japan, the United Arab Emirates, Saudi Arabia and Brazil is also opening up business doors to the U.S. – the global leader in the Aerospace and Defense sector (Read: Time to Buy This Aerospace and Defense ETF?).

Strategic alliances with other foreign nations often entail the U.S. to share its military technology and supply weapons to its allies which in turn boost the sector’s revenues.

Commercial opportunities as well

On the other hand, commercial orders are also increasing. There is a significant visibility in aerospace volume growth over the next several years based on the commercial airplane backlog.

According to Aerospace Industries Association (AAI), the U.S. aerospace and defense industry recorded a massive $99 billion in net exports in 2012. This is quite above president Obama’s goal of doubling exports by 2015, at least for this sector. The data ensures that the sector is not that hurt by the uncertainty related to sequestration.

Further, contracts with Defense Advanced Research Projects Agency (DARPA) – which develops new technologies for military and restructuring activities within companies that reduce workforce and increase productivity – are the major tailwinds in the sector.

However, the picture isn’t entirely rosy. Sequestration still remains an overhang both on the civil and military sectors. Also, the companies with limited international exposure might fall into trouble in a tight-budget U.S. environment.

That is why finding a top ranked pick in this segment is so important. In order to do this, investors can look to the Zacks ETF Rank in order to help them find a top notch aerospace and defense ETF.

About the Zacks ETF Rank

The Zacks ETF Rank provides a recommendation for the ETF in the context of our outlook for the underlying industry, sector, style box or asset class (Read: Zacks ETF Rank Guide). Our proprietary methodology also takes into account the risk preferences of investors. ETFs are ranked on a scale of 1 (Strong Buy) to 5 (Strong Sell) while they also receive one of three risk ratings, namely Low, Medium or High.

The aim of our models is to select the best ETFs within each risk category. We assign each ETF one of the five ranks within each risk bucket. Thus, the Zacks Rank reflects the expected return of an ETF relative to other products with a similar level of risk (see more in the Zacks ETF Center).

For investors seeking to apply this methodology to their portfolio in the Defense and Aerospace sector, we have taken a closer look at the top ranked PPA. This ETF has a Zacks ETF Rank of 1 or ‘Strong Buy’ (see the full list of top ranked ETFs) and details about it are highlighted below:

PowerShares Aerospace & Defense Fund (PPA - ETF report)

Launched in October 2005, the PowerShares Aerospace & Defense Fund (PPA - ETF report) – is a passively managed ETF designed to provide broad exposure to the US defense, homeland security and aerospace sector. PPA tracks the SPADE Defense Index, and has amassed a net asset base of $58.6 million.

Holding 48 stocks in its basket, the fund is moderately diversified across individual securities. The product puts more than 50% of its total assets in the top 10 holdings, suggesting that company-specific risk is higher.

The Boeing Co. (BA - Analyst Report), Lockheed Martin Corp (LMT - Analyst Report) and Honeywell International Inc (HON) are its top three holdings with a respective weight of 7.23%, 6.49% and 6.31%. These companies are offering strong growth prospects at the current level. The sector breakdown for this fund is 81.9% industrial, 15% information technology and 3.1% materials.

While this choice is an expensive one in the U.S. aerospace & defense space with around 66 bps of annual fees, its daily trading volume of 15,000 is low, but is still higher than the two other choices– iShares Dow Jones US Aerospace & Defense ETF (ITA - ETF report) and SPDR S&P Aerospace & Defense ETF (XAR - ETF report) – in this space.

The fund structure calls for a value tilt for the product, along with a focus on large cap securities. Mid cap securities are also substantial in the ETF, occupying one third of the fund. The focus on value and large cap securities makes this fund a low-risk opportunity.

PPA started the year 2013 on a solid note thanks to the optimism surrounded by the improving US economic indicators and better-positioning of the defense sector. It has returned about 17.6% for the one-year period ending Mar 31, 2013 and about 17.8% in the year-to-date time frame.

The product also pays an annual dividend yield of 1.76%. PPA has hit a low of $18.20 and a high of $25.27 in the last one year. The fund is currently hovering near its 52-week high price. PPA is strongly correlated with the S&P 500 index as indicated by an R-Squared value of 81.6%.

Should current trends continue in the market, PPA could remain a solid pick for investors seeking to make a play on the space. Budget fears have turned out to be overblown, and both aerospace and defense products are in demand across the globe, suggesting a decent outlook for PPA ahead.

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